What is Compound Interest?

It’s rumored that Albert Einstein once said that compound interest is the greatest invention in human history. Whether or not Einstein really said this doesn’t diminish the fact that compound interest can be a powerful force.

It’s important to understand how compound interest works. When considering a savings or retirement account, compound interest can help you build wealth. However, it can also work against you if you owe debt that collects compound interest.

We’ve simplified the concept in the infographic below, which shows various scenarios to help you grasp what compound interest is and how you can use it to your advantage.

HOW DOES COMPOUND INTEREST WORK TO BUILD WEALTH?

Financial institutions use two types of interest: simple and compound. While simple interest collects a percentage only on the principal, compound interest is accumulated both on the principal and through any other interest that has built up in the account.

Compound interest is most beneficial over a long period of time. This is why it’s so important to start a retirement account while you’re young. Of course, compound interest works best in these cases when you’re contributing to accounts regularly.

Note the last chart on the infographic showing how time and amount of money contributed impacts total retirement savings. By waiting until age 35 to start saving, person D had to deposit twice as much as person A each month to even come close to retiring with the same amount of money. Many people think it will be easy to catch up in this way because they expect that they’ll be earning significantly more later in life. However, as time passes, there are also more expenses you may incur – such as a mortgage, home maintenance, childcare, and health care – that may compete for your additional earnings.

Retirement isn’t the only time compound interest can be utilized. Most educational savings accounts also have compound interest. By planning for your child’s education early on, the amount you save for their colleges expenses can significantly increase due to the power of compound interest.

Feel like you never have any extra money you can put towards a savings or retirement account? Check out these six money-saving life hacks that will help you save over $3,000 each year!

HOW CAN COMPOUND INTEREST WORK AGAINST YOU?

Some financial institutions may use compound interest on credit cards and loans. In this situation, it’s important to pay off your debt quickly because the longer you have outstanding debt, the more you will have to pay.

You should always pay off your credit card in full during each billing cycle. If you don’t and choose to pay just the minimum payment, the amount that you owe will quickly grow over time because the previous balance, plus the interest on that balance, is compounded monthly.

Before getting a credit card or loan, make sure you know when your balance will compound (daily, monthly, or annually) and at what rate. This will help you understand your bill each month and allow you to prioritize paying down debts to save the most money on interest over time.

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